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PERFECT COMPETITION - Amazon S3 Powered By Docstoc

A perfectly competitive industry is highly unlikely to exist in its
entirety given the strong assumptions made about the operation of
the market.

All markets are “competitive” to one degree or another, but the
vast majority of markets are characterised as “imperfectly
competitive”. We do, though get closer to perfect competition in
many markets for agricultural and other primary commodities.
These are the only markets where there are enough sellers of
products that are near perfect substitutes for each other.

Perfect competition describes a market in which no buyer or seller has
market power. Such markets are usually allocatively and productively
efficient. In general a perfectly competitive market is characterized by the
fact that no single firm has influence on the price of the product it sells.
Because the conditions for perfect competition are very strict, there are few
perfectly competitive markets.

A perfectly competitive market may have several distinguishing
characteristics, including:

      Many buyers/Many Sellers – Many consumers with the willingness
       and ability to buy the product at a certain price, Many producers with
       the willingness and ability to supply the product at a certain price.
      Homogeneous Products – The products of the different firms are
       EXACTLY the same, e.g. salt.
      Low-Entry/Exit Barriers – It is relatively easy to enter or exit as a
       business in a perfectly competitive market.
      Perfect Information - for both consumers and producers.
      Firms Aim to Maximise Profits - Firms aim to sell where marginal
       costs meet marginal revenue, where they generate the most profit.
Main Assumptions of Perfect Competition

• Each firm produces only a small percentage of total market
output. It therefore exercises no control over the market price. For
example it cannot restrict output in the hope of forcing up the
existing market price. Market supply is the sum of the outputs of
each of the firms in the industry

• No individual buyer has any control over the market price - there
is no monopsony power. The market demand curve is the sum of
each individual consumer’s demand curve – essentially buyers are in
the background, exerting no influence at all on market price

• Buyers and sellers must regard the market price as beyond their

• There is perfect freedom of entry and exit from the industry.
Firms face no sunk costs that might impede movement in and out of
the market. This important assumption ensures all firms make
normal profits in the long run

• Firms in the market produce homogeneous products that are
perfect substitutes for each other. This leads to each firms being
price takers and facing a perfectly elastic demand curve for their

• Perfect knowledge – consumers have perfect information about
prices and products.

• There are no externalities which lie outside the market
Evaluation: The Realism of Perfect Competition as a Model

Many economists have questioned the validity of studying perfect
competition. However the theory does yield important predictions
about what might happen to price and output in the long run if
competitive conditions hold good.

There are still markets that can be considered to be highly
competitive and in which competition has strengthened in recent
years. Good examples of competitive markets include:

•           Home              and            car             insurance
•              Internet               service                providers
• Road haulage

Such markets are likely to exhibit the following features:

• Lower prices - because of the large number of competing firms.
Suppliers face highly elastic demand curves and any rise in price
will lead to a large fall in demand and total revenue. The cross-
price elasticity of demand for one product with respect to a change
in the relative price of another will be high

• Low barriers to entry – new firms will find it easy to enter
markets if they feel there is abnormal (economic) profit to be
made. The entry of new firms provides extra competition and
ensures prices are kept low

• Lower profits than those in markets dominated by a few firms

• Economic efficiency – competition will ensure that firms attempt
to minimise their costs and move towards productive efficiency.
The threat of competition should lead to a faster rate of
technological diffusion, as firms have to be responsive to the needs
of consumer. This is known as dynamic efficiency
According to the Pure or perfect competition, or ideal, only if they possess
the following characteristics
                 Every industry must have hundreds of firms and
                  potential entrants, each firm with tiny shares of the
                  overall market.
                 Potential entrants must have equal and virtually cost-
                  free access to the industry.
                 Each firm must be completely devoid of any power to
                  influence the price of his product or to alter his market
                 Within each industry the products and services of each
                  firm must be virtually indistinguishable from those of
                  other firms; with no need to differentiate one's
                  offerings, ideally there should no promotion or
                  advertising; if there is, it's a waste.
                 Profits are non-existent; if then exist there is an
                  imperfection. Prices would be too high. A firm's price
                  should only cover a its "marginal costs"--those are the
                  variable costs a firm incurs, the extra costs needed to
                  produce extra goods, such as materials, fuel, inventory
                  and labor; in pricing its product a firm does not cover
                  fixed costs, those costs associated with plant,
                  equipment, and patents, because these assets already
                  exist. Since, in fact, fixed capital wears out and must
                  be replaced, the requirement that price cover only
                  marginal costs means that the "ideal" situation is firms
                  showing losses.
                 Finally every firm, consumer and investor must have
                  cost-less and "perfect information" about the state of
                  prices, production, employment and markets as well as
                  of each others' intentions--this despite the fact that it
                  costs time and effort to produce valuable information
                  and despite the "ideal" requirement that there be no
       The firm’s objective is to produce the level of output that will
        maximize profit.
       Economic profit = total revenue minus total economic cost.
          o Total revenue = price x quantity sold.

The Revenue Structure of the Competitive Business Firm

   The perfectly competitive firm is a price-taking firm. This means
    that the firm takes the price from the market.
   As long as the market remains in equilibrium, the firm faces only one
    price—the equilibrium market price.

Computing the Total Revenue of a Price-taker

   Since the perfectly competitive firm faces a constant price, the
    shape of its total revenue is an upward-sloping line. Total revenue
    changes only with changes in the quantity sold.

The Totals Approach to Profit Maximization

       To maximize profit, a producer finds the largest gap between
        total revenue and total cost.

The Marginal Approach

       The other way to decide how much output to produce involves
        the marginal principle.

Increase the level of an activity if its marginal benefit exceeds its
marginal cost, but reduce the level if the marginal cost exceeds the
marginal benefit. If possible, pick the level at which the marginal
benefit equals the marginal cost.
Marginal Revenue

     The benefit of producing and selling rakes is the revenue the
      firm collects. If the firm sells one more rake, total revenue
      increases by $25.

         Marginal benefit = marginal revenue = market price

The Marginal Rule for Profit Maximization

     A firm maximizes profit in accordance with the marginal
      principle—by setting marginal revenue (or market price)
      equal to marginal cost.

Profit Maximization Using the Marginal Approach

Economic Profit

     Profit per unit equals revenue per unit (or price) minus cost per
      unit (or average total cost).

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